A big regulator for the little investor

Almost six months ago, Treasury Secretary Henry Paulson proposed an ambitious consolidation of the regulatory agencies that police the nation’s financial system. Unfortunately, since then the Bush administration and the Federal Reserve have been so busy reacting to crises — just this week, taking over Fannie Mae and Freddie Mac and trying to broker a sale of Lehman Brothers — that these long-term, systemic remedies have been punted to the next president.

The idea of a financial supercop should be embraced by a McCain or Obama administration. The place to start should be with a re-examination of the Gramm-Leach-Bliley Act of 1999, which removed the 66-year-old separation between commercial banks (the kind that accept deposits and make loans) and investment banks (the kind that underwrite securities).

The separation began with the Banking Act of 1933, also known as the Glass-Steagall Act because it was written in the aftermath of the stock market crash of 1929 by Senator Carter Glass of Virginia and Representative Henry Steagall of Alabama. The idea behind it was twofold: first, diffuse what was thought to be an excessive concentration of financial power in a limited number of large institutions, and second, prevent unsophisticated investors from being sold risky investments when they thought they were placing their savings in what we now call money-market accounts.

Competitive disadvantageBy 1999, however, the idea that risky investments and public deposits should never be offered by the same institution had become an anachronism of the New Deal. Foreign banks like UBS and Deutsche Bank engaged in both underwriting and in lending and deposit-taking, which put American banks at a competitive disadvantage in the global marketplace.

But when lawmakers permitted commercial banks and investment banks to merge into new behemoths like Citigroup, they did not follow through on the logical implication of their idea — fusing the industry’s regulatory overseers into a similar colossus. Instead, Congress allowed the government’s financial regulatory structure to remain stuck in the 1930s, split among an array of agencies.

This piecemeal alteration of the law is continuing today. Earlier this year, for the first time since Glass-Steagall was enacted, the Federal Reserve allowed investment banks direct access to cheap, short-term loans from the Fed’s discount window — a privilege that by law had been limited to commercial banks. It was a necessary government response to a crisis. But the issue of oversight, of increased responsibility in exchange for increased privileges, remains unaddressed. The Federal Reserve Act of 1913 (another one of Carter Glass’s creations) needs to be amended to permit the Fed to oversee both investment banks and commercial banks in a financially integrated world.

Focus on preventionWe must avoid simply merging regulators and hoping for synergies. We need a system that focuses on the prevention of crimes and crises (similar to the British Financial Services Authority) instead of aiming only for after-the-fact discovery and punishment. Right now, the Securities and Exchange Commission conducts backward-looking audits, searching for past transgressions. Instead, federal regulators should focus on guiding companies, helping them to adhere to sound principles of risk management and to avoid imprudent business practices.

It is also time, though, to build a new wall of separation. Today, complex financial instruments like structured investment vehicles and auction-rate securities are marketed to unsophisticated buyers ranging from retail investors to corporate and government treasurers. In 1933, Glass-Steagall addressed the imbalance of power between the investors and the providers of financial services by separating the providers into commercial banks and investment banks. Seventy-five years later, instead of trying to limit what products innovative financial firms can offer, it would be more prudent to limit the markets to which they can sell their wares.

In other words, the customers, not the companies, should be divided. This could be accomplished by extending the current system of government classification of “qualified investors,” used to limit who can invest in things like hedge funds. By demonstrating expert knowledge or the ability to absorb loss (because of high net worth), qualified investors could be given a pass into the caveat emptor world of modern Wall Street. Those without the inclination, the sophistication or the deep pockets to qualify would be limited to the more closely regulated menu of stocks, bonds and mutual funds.

Prudent regulationThe lesson from the financial crises of the 20th century is that responsible politicians are not socialist demons trying to destroy capitalism. Carter Glass saved American capitalism through prudent regulation that prevented past excesses without stifling new innovation. The next administration will need to accomplish that feat again.

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